Owning your own home has long been a quintessential part of the American Dream and it will undoubtedly be the biggest investment/purchase that most people will ever make. Owning a home gives people a sense of pride, can help them build wealth over the long-term, and is a corner-stone of many people’s retirement plans.
This post will explore some of the considerations you need to make before you make your home purchase, will look at the benefits of home ownership, and will examine some of the potential pitfalls and costs of ownership. Don’t miss out on FIRE by making a bad choice on your biggest investment decision.
Before you Buy
Before you decide to purchase your own home there are several questions you need to answer and several financial items you need to take into consideration to determine if you can afford to make the leap to home ownership and if now is the right time to become a home owner.
To determine if you can afford to buy a home you need to look at the following:
- Down-payment. Although down-payment amounts have continued to come down you’ll still need to be able to put 3.5% to 5% down as a minimum. That means on a $250,000 home you would need to put a down payment of $8,750 to $12,500. However, it’s not uncommon for some lenders to want 10-20% as a down payment. In a high-cost city such as New York or Washington DC where entry-level housing could easily top $500,000 that means that you might need as much as $100,000 for a down payment. Making your down payment should never force you to liquidate your emergency savings fund!
- Insurance. Since you’ll want to protect your investment you’ll need insurance. Insurance costs will vary significantly from state to state based on the risk (i.e., you’ll need more insurance if you live in an area with tornados and hurricanes). In high cost areas like Houston, Texas you might have rates as high as 1% per year of your home’s value, meaning a $250,000 home would cost $2500/year to insure, while in lower areas like North Carolina’s Greensboro area you might have rates as low as 0.25% per year, meaning you can get the same coverage for $625/year.
- Utilities. Your house won’t do you much good if you can’t afford electricity, water, sewer, gas, internet/phone, etc. You should have a good estimate of these from your current living situation, but it is important to remember that if you buy a larger or older home than you might see your bills go up substantially.
- Property Taxes. Property taxes vary substantially by state, county, and city. In some areas they will cover costs like garbage and sewer (as well as things like Police, Fire Department, and Schools). There is often a trade-off between high property taxes and low state income taxes as your local governments will find a way to get their slice of the pie.
- HOA Fees. HOA fees, especially in condominium and townhome complexes with amenities like pools, landscaping, and clubhouses can run into the hundreds of dollars per month. If you are in a new build high-rise with a pool, gym, concierge, on-site security, and where the building covers most of the insurance costs for the structure you might have costs that can be over $1000/month.
- Mortgage Interest. Mortgage interest, although tax deductible, is not free of costs. If you pay $10,000/year in interest on your loan and are in a 20% tax bracket, you will still end up paying $8,000 net interest charges after your tax break.
- Maintenance. After you’ve bought your dream house what happens if the A/C dies, a pipe breaks, or your kid’s baseball breaks a window? You’ll need to have at least some money in your budget for doing routine maintenance. I like to budget quarter of a percent per year, meaning that if my home costs $250,000 I’ll spend about $625 on repairs. You should note that you might spend nothing for 3 years, then $5,000 repairing a leaky roof, and then have nothing again for another 3-4 years, but it does need to be accounted for. Also, if you have a yard you’ll need to buy equipment for keeping it green and trimmed.
Once you have determined that you can afford a home, you then need to determine if NOW is the right time. The biggest considerations are:
- Moving. Given that you’ll have loan origination costs when you buy and real estate agent’s fees when you sell, you need to plan to live there for at least three to four years. Agent’s fees on a $250,000 home can cost you up to $15,000, meaning that you’ll need to see capital appreciation of at least that much just to break even. This means that in all likelihood, unless you are in a very hot real estate market, that you’ll need to live there for at least 3-4 years. Otherwise, you won’t get to enjoy the benefits of value appreciation.
- Location, Location, Location. Since real estate values are driven by location many first-time buyers will be tempted to buy in parts of town that they can afford instead of buying in parts of town where they want to live. I view this as a mistake. It’s better to wait a year or two and invest in the area you want to live instead of settling and having to live with the consequences of a rushed purchase for several years.
- Apprehension. If you can’t stand the thought of having a mortgage hanging over your finances or if you don’t feel responsible enough to make the commitment, you should wait. It is especially important that you don’t let yourself get talked into buying before you are mentally ready by friends and family who mean well, but don’t recognize your nervousness.
Benefits of Home Ownership
The benefits of home ownership are myriad, and there are more than I can go through, but here is a short list of many of the top reasons:
- Value Appreciation. In most cases home values, with the exception of the financial crisis, home values will climb steadily through time, typically at 1-3% per year. At a 2% increase per year, this means your $250,000 home will grow to a value of over $440,000 in 30 years, the typical length of a mortgage. And best of all, most capital gains from selling your primary residence are tax free!
- Tax Deductions. Home owners get to write off many expenses on their taxes, including mortgage interest and property taxes. This preferential treatment can mean big savings if you are in a higher tax bracket.
- Building Equity. Every month as you make your payment you are building equity in your home. This means instead of the money going to your landlord it is essentially going into the home that you own. Although this may not seem like much at first, over the long-term it will add up and put you on the path toward FIRE.
- Forced Savings. Related to building equity since you are required to make a payment every month the amount you pay in principal is essentially a forced savings mechanism. Although most of our readers will be good at saving money already, for those who aren’t this can be a powerful tool.
- Pride and Stability. The non-financial benefits of home ownership are that you often have a sense of pride in owning your own home and that it gives you and your family a sense of stability. You have a place that is yours that you can come back to day after day.
Potential Pitfalls and Costs
Home ownership can be great, but it can also be a nightmare. If you’ve never seen the Tom Hanks movie The Money Pit you should… because if you buy the wrong house you’ll find yourself living in the proverbial money pit.
Discovering hidden problems after you make a purchase can be a real financial headache and a major source of stress. That is one reason why I always advocate for getting a thorough home inspection before buying. You don’t want to move in only to find out that the plumbing is leaky, there’s mold in the walls, termites eating away at your foundation, shingles missing from the roof, or that there’s a colony of mice living in your attic insulation. Paying for fixes is never fun, but it is especially trying when it comes on the coattails of making a down payment, making your first home owners insurance payment, and splashing out for other closing costs.
With respect to what you buy, the biggest secret is to buy something you love in a location you love. If you are buying a house you love in an area you hate, or a house you hate in an are you love, you are setting yourself up for disappointment. And, if you are disappointed it will likely show up in the dollars and cents too, because it is likely that you bought the wrong house or in the wrong location, which means you won’t see the value appreciation benefits.
Home ownership has many benefits, but you need to do extensive homework before you buy your home. It is a huge investment both financially and emotionally, if you aren’t prepared or you’ve cut corners then you may end up regretting. However, if you do it right and avoid some common pitfalls, then you’ll be taking an important step on the road to FIRE!
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